Hot financial stuff
There is a myriad of financial considerations highlighted in this case. They include treatment of technical and market research costs of the product line, incorporating effects of new product line on the old product line, as well as the determination of the residual and economic values of an investment. The required rate of return is also highlighted in this case. Felipe Mendez requires a minimum return of 25% on any investment he makes.
R&D is an expense incurred in the development of new products. R&D should be computed and expensed off in the firm’s income statement in the year it is incurred. The new line project is expected to generate revenues for the company. The matching concept requires that revenues should be matched with expenses incurred in generating them (Harrison, Horngren and Thomas, 2013). The benefits of R&D expenditure are expected to accrue in future periods. Since the amount of cost applicable to the future is difficult to measure with certainty, the whole amount is expensed off in the year it is incurred (Harrison, Horngren and Thomas, 2013). Besides, the amount of R&D is too high to ignore. The company spent 135,000 euros in technical and market research.
The residual value is calculated by deducting accumulated depreciation from the book value of an asset (Harrison, Horngren and Thomas, 2013). The real value of an asset is the nominal value or price adjusted for the effects of changes in the general price level. Economic value is determined by getting the sum of all benefits expected from the asset during its useful life.
Working capital changes
Working capital requirement is high during the initial years of the new product line. This is because the firm’s efficiency is low in the initial years hence it takes a longer time to convert inventory into finished products and finished products into sales. Therefore, more capital is required in the initial years to finance operations (Hillier, 2013). Efficiency improves in the subsequent years due to the learning curve effect. The initial years are also characterized by a substantial long-term investment which crowds out finances for daily operating activities (Hillier, 2013). Besides, debt collection improves in subsequent years, thus lowering working capital needs.
Spillover effects should be taken into account in the evaluation of the new product line. New product lines should be evaluated based on the impact on the profitability of the overall organization. Thus, all incremental costs and revenues, including opportunity cost should be considered (Hillier, 2013). The new product line will cause a significant cannibalisation of the old design tools, hence this impact should be included in the analysis. The lost revenue due to cannibalisation of the old product line should be included as an opportunity cost of introducing the new product line.
Harrison, W., Horngren, C. and Thomas, C. (2013). Financial accounting. Boston: Pearson.
Hillier, D. (2013). Corporate finance. London: McGraw-Hill.